Stress Testing Can Help Troubled State Public Pension Funds

This article was originally published by The Pew Charitable Trusts and was written by Greg Mennis and Stephen C. Fehr.

The pension system for state workers in New Jersey is so underfunded that it could run out of money in 12 years. Pennsylvania and Connecticut have taken steps to stabilize their systems, such as increasing state contributions, but policymakers face the prospect of high pension costs for years to come. And Colorado could deplete its retirement fund assets by 2044 because the state lacks policies to manage volatile financial markets.

These gloomy projections are among those in a first-of-its-kind simulation of state pension system funding conducted by The Pew Charitable Trusts. A new study, "Assessing the Risk of Fiscal Distress for Public Pensions: State Stress Test Analysis," presents findings about the largest public employee plans in 10 states: Colorado, Connecticut, Kentucky, New Jersey, North Carolina, Ohio, Pennsylvania, South Carolina, Virginia, and Wisconsin. The John F. Kennedy School of Government at Harvard University published the report on May 23, 2018.

Not all of the 10 states assessed by Pew are in bad shape. North Carolina and Wisconsin, both hard hit by the Great Recession of 2007-09, fully fund their retirement systems by following well-designed contribution policies that are adjusted depending on economic conditions. Every state in the study has enacted reforms since the Great Recession and should expect declines in costs over time as savings are realized from those changes.

The analysis shows the advantages of nonpartisan, evidence-based financial stress testing to inform policymakers about the impact of economic uncertainty on a state's ability to pay benefits to retirees. The Pew model incorporates a range of scenarios for economic projections and investment returns, which can give policymakers a better sense of potential liabilities and costs.

The findings could bolster efforts by state policymakers to strengthen their retirement system finances, which along with Medicaid are the top spending pressures facing states today. Pew recently pegged the cumulative gap between state pension fund assets and liabilities at $1.4 trillion. Money used to close that shortfall represents dollars not available for other priorities such as education or public safety.

Warning that state retirement system finances and government budgets could face greater risk of rising costs in the next economic downturn than in any previous recession, Pew's analysis concludes that state legislators should require pension stress test reporting to quantify the estimated impact of lower returns on pension balance sheets and state finances.

The median return assumption was 7.5 percent for public pension plans in 2016, but many analysts expect returns to be a full percentage point lower over the next two decades. Some say there is about a 1 in 4 chance that returns may not rise above 5 percent in that period. Although many states have lowered their assumed rates of return, fund investment targets still exceed industry estimates at a time when state reporting does not adequately account for economic uncertainty and market risk.

Momentum Growing for Stress Testing

Seven states—California, Colorado, Connecticut, Hawaii, New Jersey, Virginia, and Washington—recently moved to require pension plan stress testing. Pew evaluated the plans in four of those states.

Pew's model is patterned after requirements for financial institutions in the 2010 Dodd-Frank Wall Street reform legislation. Using multiple economic scenarios and rates of return can show what states and employees would need to contribute over time to fully fund their retirement systems.

One scenario, for example, applies a fixed 5 percent rate of return, while another assumes an initial investment loss of 20 percent, followed by low returns over many years. State tax revenue projections are factored in to measure the impact of economic downturns on state budgets. The model also can account for the possibility that policymakers will underfund required pension contributions.      

Results Broadly Applicable

Though Pew tested 10 states, the findings can apply to all. Among the general conclusions, the analysis shows that:

• States with low pension fund levels and minimal contribution rates could face insolvency. Using the fixed 5 percent return scenario, New Jersey's assets would be depleted by 2030. Future retiree benefits would have to be paid out of the state budget and from increased employee contributions. In New Jersey, that would double annual costs and require steep budget cuts or tax increases. State policymakers have taken initial steps to address the crunch, planning to triple state contributions over the next five years and adopt stress testing to monitor progress.
   
• States with low funded levels that have increased pension contributions probably will not run out of money, but could pay permanently high costs if return targets are not met. Pennsylvania and Connecticut increased the state share of pension contributions to more than 30 percent of payroll, and each offers new hires a less costly hybrid benefit plan. But because of serious past underfunding, the simulations found that projected cost increases could persist for decades, draining state dollars from other services and programs.
   
• States with funding policies that do not respond to market downturns risk distress and insolvency. Many states design their pension funds so contributions can be increased to cover the rise in unfunded liabilities during a downturn. Colorado and Ohio do not, instead setting a fixed maximum state contribution. Unless these states change their policies, the model shows pension fund assets in both could be exhausted within 30 years if investment returns are lower than expected.
   
• Some state retirement system policies do not include adequate plans for managing costs in cases of extreme market volatility. Although South Carolina's pension fund would not be distressed under the fixed 5 percent return, the analysis shows a heightened risk of insolvency if the plans face more severe economic conditions. Current state policies do not fully protect against contribution shortfalls during downturns, although officials recently implemented reforms and are considering additional steps that Pew's stress testing indicates are necessary. Neighboring North Carolina, by contrast, is among the nation's best funded pension systems, with a policy to increase contributions and pay down unfunded liabilities more rapidly than other states.
    
• Policies that call for cost-sharing between employees and the state government reduce risk and make state pension costs more predictable. Wisconsin's unique defined benefit plan automatically raises employee contributions to cover unexpected cost increases, but it also boosts pension payments if investment returns exceed specific benchmarks. Uncertainty over long-term economic growth and the fragile nature of public pension funding demand policy solutions that manage volatility and lower state costs. The problem is only going to worsen as more members of the baby boom generation retire and pension money is paid out of state treasuries faster than it is coming in. Stress testing gives policymakers a clearer sense of how future economic downturns could affect pension finances, critical insight when setting policies that protect taxpayers and retirees.